This Hot Stock Might Be Due for a Pullback And Deliver A Gain
Trade summary: A bear call spread in Wayfair Inc. (NYSE: W) using June $150 call options for about $18.05 and buy a June $155 call for about $14.60. This trade generates a credit of $3.45, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $1.55. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($345). This trade offers a potential return of about 122% of the amount risked.
Now, let’s look at the details.
W has been one of the strongest stocks since the market bottomed in March.
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What's at stake?
The U.S. economy, the stock market and, most importantly, the U.S. dollar. One of the world's leading resource experts said, "If you were hurt by the 2008 financial crisis, you're going to want to be prepared for this."
Now, some analysts are questioning if the stock ran up too much in the short run. Some argue the stock needs to pause so that fundamentals can catch up with the price action. Among those analysts, as the The Street noted, are analysts at Citi.
Recently, the firm downgraded W to sell from neutral.
Wayfair shares had risen by a factor of more than 7 from March to their recent high. This represented a total return of more than 90% since the beginning of the year.
The article in The Street explained, “Citi analyst Nicholas Jones, who raised his price target on Wayfair to $130 a share from $75, said in a note to clients that even though estimates moved higher on better-than-anticipated trends, the company’s shares are overvalued.
The analyst said that while Wayfair is seeing a near-term benefit from shelter-in-place and social-distancing measures, trends will revert to those of a pre-coronavirus environment.
Long term, Jones said the adoption of online channels will likely increase, but the cost to maintain order volume will also increase back to outbreak levels, pressuring Wayfair’s profitability.
In April, Wayfair said that its revenue-growth rate doubled amid the coronavirus pandemic.
Shelter-in-place and social-distancing requirements have devastated most businesses, which have been forced to close or severely limit their services.”
Citi is not the only firm commenting on W. Evercore ISIS analyst Oliver Wintermantel also cut his rating on the company to in line from outperform, noting that the stock had moved far enough, and that further upside will be challenging.
Fundamentals are not as exciting as the stock’s move implies. In the most recent quarter, the company announced that its net loss grew to $289.9 million, or $3.04 a share, from $200.4 million, or $2.20, in the same three months a year ago.
Revenue totaled $2.33 billion, up from $1.94 billion a year earlier and ahead of the $2.31 billion that analysts had expected.
The long term chart shows the recent price move has been parabolic and a pullback should be expected.
Buying shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for W
For W, we could sell a June $150 call for about $18.05 and buy a June $155 call for about $14.60. This trade generates a credit of $3.45, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $345. The credit received when the trade is opened, $345 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $155. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($345).
This trade offers a potential return of about 122% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if W is below $150 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $155 for this trade in W.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.